One thing we’ve covered quite extensively of late is the growing fiscal crisis [11] facing state and local governments in the US.
To recap a few of the more important (and amusing) stories, recall that Chicago recently saw its debt downgraded to junk status by Moody’s after the Illinois Supreme Court struck down a pension reform law which would have paved the way for Mayor Rahm Emanuel to push for similar changes in Chicago where underfunded pension liabilities are set to triple [12] by 2018. Adding insult to injury, Moody’s decision also triggered some $2 billion in accelerated payment rights for the city’s creditors and jeopardized the refinancing of some $900 million in floating rate paper.
Meanwhile, in Kansas, GOP Governor Sam Brownback’s tax cuts have backfired [13], helping to blow an $800 million hole in the state’s budget resulting in cuts to education and proposed worker furloughs and prompting one angry waitress to advise Brownback to “tip the schools” rather than his server.
Down south things aren’t much better as falling oil prices have plunged Louisiana into a $1.6 billion fiscal abyss that’s now threatening to bankrupt [14] LSU.
Visually, the situation looks like this...
[15]
Now, lawmakers fear the Illinois Supreme Court may have set a precedent that will hamper efforts to cut pension costs meaning state and local government officials will need to figure out alternative ways to plug the holes and as you might have guessed, option number-one is ...drumroll… more debt.
The New York Times has more [16]:
Facing a shortfall of more than $50 billion in his state’s pensions, and with no simple solution at hand, Gov. Tom Wolf of Pennsylvania is proposing to issue $3 billion in bonds, despite the role that such bonds have already played in the fiscal woes of other places.
And he is not alone. Several states and municipalities are considering similar action as they struggle with ballooning pension costs.
Interest in so-called pension obligation bonds is expected to intensify in the wake of a recent Illinois Supreme Court decision that rejected the state’s attempt to overhaul its severely depleted pension system. The court ruled unanimously that Illinois could not legally cut its public workers’ retirement benefits to lower costs, forcing lawmakers to scramble for the billions of dollars it will take to keep the system intact.
While the Illinois ruling is not binding on other states, analysts think it may influence lawmakers elsewhere to look to alternatives to cutting public pensions…
“My reaction was, ‘Yeah, that’s going to play here,’ “ said John D. McGinnis, a lawmaker in Pennsylvania, which has also been diverting money from its pension system, setting the stage for a crisis as more and more public workers retire. The state has no explicit constitutional mandate to protect public pensions, as Illinois does, but that is irrelevant, said Mr. McGinnis, a Republican and former finance professor at Pennsylvania State University.
“The judiciary in Pennsylvania has been solidly of the belief that there are ‘implicit contracts,’ and you can’t deviate from them,” he said. If lawmakers in Harrisburg were to unilaterally cut pensions now, he said, they could be taken to court and be dealt a stinging rebuke, like their counterparts in Illinois.
'Solving' this problem by issuing bonds is an enticing option but at heart, it amounts to what one might call a "pension liability-bond arbitrage." The idea is to borrow the money to plug the pension gap and invest it at a rate of return that's higher than the coupon on the bonds, thus saving money over the long-haul.
Of course, much like transferring a balance on a high interest credit card onto a new card with a teaser rate (or refinancing a high interest credit card via a P2P loan) this gimmick only works if you do not max out the original card again, because if you do, all you've done is doubled your debt burden. As it relates to pension liabilities, this means that what you absolutely cannot do is use the cash infusion as an excuse to get lax when it comes to pension funding because after all, that's what caused the problem in the first place. Here's NY Times again:
Fiscal analysts say it is possible, in theory, to shape a pension obligation bond deal responsibly, but that is not what they usually see.
Instead, the deals are typically used to make troubled pension systems seem a little less troubled for a few years, allowing elected officials to celebrate a pension reform without having to make the system sustainable over the long term.
The flood of cash from the bonds may also tempt officials into taking a break from their pension-funding schedule — the very action that has caused so much pension distress to begin with. Skipping annual pension contributions produces an off-balance-sheet debt that can start growing exponentially.
Aside from the rather obvious fact that borrowing huge sums of money to paper over problems has a tendency to promote the very same type of irresponsible behavior that got the borrower into trouble in the first place thus setting the stage for a scenario that ends up being twice as bad as it was initially, there's also the fact that, as documented in these pages extensively [17], investment return assumptions for public pension plans are often at odds with reality. That is, projecting a 7% return in a world governed by ZIRP and NIRP means that in the best case scenario you are being absurdly optimistic and in a worst case scenario you're likely taking greater risks in an effort to maximize returns. Reinforcing the latter is the following graphic which shows the extent to which pensions have moved increasingly into riskier assets over time in an effort to stay solvent in a low rate environment:
And, for those who missed it, here is a sampling of the return assumptions from Chicago's local government pension plans (ask yourself how one can possibly hope to hit these targets by investing conservatively in today's markets):
[18]
As for pension obligation bonds well, they aren't necessarily something you want to get involved with if you're a yield-starved investor because as it turns out, helping broke states and municipaltiies perpetuate pension ponzis sometimes ends very poorly:
After declaring bankruptcy in 2013, Detroit sought to have $1.4 billion of pension obligation bonds voided outright, saying they had been sold illegally in 2005 and were not enforceable. Ultimately, Detroit settled the debt for about 13 cents on the dollar, the lowest recovery rate of any of its bonds.
Meanwhile, in San Bernardino, California (a city which still finds $650,000 to pay off victims of post-horse chase police brutality [19]), investors learned the pension obligation bond lesson the hard way.
Via Bloomberg:
U.S. Bankruptcy Judge Meredith Jury on Monday threw out a lawsuit in which investors had claimed their pension bonds must be paid off at the same rate as the California Public Employees’ Retirement System in the San Bernardino bankruptcy. The $304 billion fund is the biggest in the U.S.
Jury acknowledged that her decision may discourage investors from buying pension-obligation bonds in the future.
“What I see as unfair, and might seem unfair to the outside world, does not matter under law,” Jury said, referring in part to the powerful remedies Calpers can seek if the city doesn’t honor its contract...
An investor who buys pension-obligation bonds “is just asking for trouble,” said Cohen, who manages $345 million for individual investors. The cities’ bankruptcies show that pensioners and municipal employees have an advantage over bondholders, she said.
In the end, at least one concerned Pennsylvania citizen (who is ironically a retired state employee) gets it and because we appreciate his candor, we'll give retired accountant Barry Shutt the last word:
“When you’re borrowing money for pensions, you’re getting a new credit card to pay off the old one, and you still haven’t paid off the old one.”
